Dividend Valuation Model (DVM)

The value of common stock is equal to the present value of periodic future dividends which stock holder expects
that company will distribute forever.
The model is based upon two basic principles:
i) Share price today depends upon future cash flows.
ii) $1 received today is better than $1 of tomorrow. (The concept of time value of money)
Different forms of dividend valuation model
i) Zero growth model
ii) Constant growth model (Gordon’s growth model)
iii) Multi-stage dividend model
1) Zero growth model
It is the basic version of DVM which considers fixed dividends for investors forever. So price of security will be:
P0= DIV (t) /r
r = DIV (t) / P0
Where
P0 = Current stock price
r = required rate of return (i.e. cost of equity)
DIV (t) =Annual dividend at time period t
Example 1 (Zero growth)
Stock ABC is expected to pay dividend of $10 forever. The required rate is 10 %. The stock price today will be
P0= DIV (t) /r
= 10 / 0.10 = $100
Note
 The valuation formula reduces to the equation of PV of perpetuity.
 DIV (t) is taken because common stock does not have a fixed life. So infinite streams of dividends must be
forecasted.
2) Constant growth model (Gordon’s growth model)
This part of DVM model considers constant growth in dividends. It is also called Gordon’s Growth model. So price
of security will be:
P0= DIV1 /(r-g)
r = (DIV1/ PO) + g
DIV1 = DIV0 (1 + g)

Where
P0 = Current stock price
r = required rate of return (i.e. cost of equity)
g = Constant growth rate
DIV1 = Dividend to be paid at time period 1
DIV0 = Current dividend
Determination of growth rates
Normally the growth rates are given in the question but if they are not given then they can be calculated in two
possible ways:
i) Gordon’s Growth Model

Growth rate can be determined by the following formula:

g = br

g = growth rate
b =retention ratio
= (Retained Earnings /PAT) OR (1- Payout Ratio)
Payout ratio = (Dividends/PAT) OR (1- Retention Ratio)
r = return on equity = (EPS / book value of equity)
(or) (Net income/ Shareholders equity)

ii) Averaging Method

g = [(d0/dn) 1/n] -1
d0 = current dividend
dn = dividend n years ago

Note:
Growth rate formula is used to calculate both growth rate in dividends and growth rate in book value
Determinants of growth rate
i) Size of investment.
ii) Rate of return of new investment
iii) Retention ratio
Example 2 (Gordon growth)
Consider two firms with identical required returns of 10% per annum. Firm A has expected earnings of $5 per
share over the next year and for every subsequent year and commits to paying out all of those earnings as
dividends. Firm B has identical expected earnings to firm A in the next financial year but commits to a policy
whereby it always ploughs back 10% of earnings into investment projects. The remaining earnings are paid out as
dividends. Its return on equity is 20%.
REQUIRED
i. Compute the market values of the two firms and the present value of growth opportunities for firm B.
ii. Explain the source of the difference in the values of the two firms with reference to the underlying data.

ANSWER
(i)
Firm A PAYS ALL EARNINGS AS DIVIDENDS
P0= D1 /r = 5/0.1 = $50
Firm B PAYS DIVIDENDS 90% AND RETENTIONS 10%
P0= D1 /(r-g) = 5 x90% = 4.5/ (0.1-0.02) = $56.25
g = br
0.1 x 0.2 = 0.02
PVGO = FIRM B VALUE – FIRM A VALUE
=56.25 – 50 = $6.25

(ii) WHY DIFFERENCE ARISES

Higher expected dividends in firm B as compare to A (due to re investment)
If ROE > cost of capital (r) then VB > VA
If ROE < cost of capital (r) then VB < VA
If ROE = cost of capital (r) then VB =VA

EXAMPLE 3 (Averaging method)

A company operates in the pharmaceutical industry where the required rate of return is 16%. Annual dividends
per share have been and are anticipated as follows:
Time period Dividend per share
(pence)
Last year 12.47
Current year 13.10
Anticipated for next year 13.75
Required:
Calculate the market value of share

Answer
P0= D1 /(r-g) = 13.10 (1+0.05)/ (0.16-0.05) = 125 pence approximately
Calculation of g by using averaging method
g = [(Latest dividend/Earliest dividend) 1/n] -1
g = [(13.75/12.47) 1/2] -1 = 5 % approximately
Appropriateness of the model
This model is only appropriate for those companies which pay dividend at a constant rate or a constant growing
rate. Normally mature companies pay dividend at a constant rate or a constant growing rate. So this model is not
appropriate for newly established firms.
Important considerations
i) Company must distribute dividends
ii) The value of r must be greater than g.
Assumptions
1) Company exists forever.
2) Dividend is expected to grow at a constant rate forever.
3) Stock price is expected to grow at a constant rate forever.
4) Required rate of return is greater than growth rate
5) The total expected return is equal to the dividend yield and capital gain yield.
Advantages
1) Easy application for stable and mature firms.
2) It is simple to understand.
3) Investor can calculate share price by considering current market conditions.
4) Dividends are easy to forecast in short run (Predictability).
5) It gives options to grow value of the portfolio.
6) It operates within a margin of safety.
7) It eliminates subjectivity from the equation.
Disadvantages
1) Constant growth in dividends is very rare.
2) Model is worthless if g > r.
3) Model is not applicable on those firms which do not pay dividends.
4) Model is not applicable on newly established firms.
5) It ignore other factors which may affect stock prices (like inflation, economic growth, investor loyalty,
satisfaction etc.)
6) It ignores taxation rules.
7) Input data may be inaccurate. For e.g. current market value, future dividend pattern etc.
8) P0 is hyper sensitive to g
Dividend Valuation Model (Derivation)
Zero growth
Expected return on a stock over the next year (E(R)). It is a function of the expected dividend and expected capital
gain. Formally this can be written as:
E(R) = (DIV1 +P1 – P0)/ P0…………… (i)
Where
DIV1 = expected dividend to be paid at time 1
P0 = current price of the stock
P1 – P0 = capital gain on the stock
Rearranging equation (i) for P0
E(R) = (DIV1 +P1 – P0)/ P0 = [(DIV1 +P1) / P0] -1
P0 = DIV1 +P1/ (1 + re)
r = required annual rate on similar equity stocks.
We predict the current price of a stock in terms of dividends over N years and the price at the end of year N:

…………. (ii)
As the horizon period N approaches infinity, the present value of the terminal price approaches zero.

………………. (iii)
DIVt = dividends to be paid annually at time t. Because a common stock does not have a fixed lifetime, an infinite
stream of dividends must be forecast.
Equation iii can be shown as
P = DIV / (1+ re)1 + DIV / (1+ re)2 + DIV / (1+ re)3……………….. (iv)
Dividing both sides of equation 4 by (1 +re)
P / (1+ re) = DIV / (1+ re)2 + DIV / (1+ re)3+ DIV / (1+ re)4 …………………. (v)
Subtracting equation (v) from equation (iv)
P – [ P / (1+ re)] = DIV / (1+ re)1
To avoid fraction multiply all by (1+re) (i.e. taking LCM)
P (1+re) – P = DIV
P + Pre – P = DIV
Cancelling P the expression will be
Pre = DIV
P = (DIV/re)
Constant Growth
P = DIV (1+g)1 / (1+ re)1 + DIV(1+g)2/ (1+ re)2 + DIV(1+g)3 / (1+ re)3……………….. (i)
Multiplying both sides by (1+g)/ (1+re)
P (1+g)/ (1+re) = DIV (1+g)2 / (1+ re)2 + DIV(1+g)3/ (1+ re)3 + DIV(1+g)4 / (1+ re)4…… (ii)
Subtracting equation (ii) from equation (i)
P – [P (1+g) / (1+ re)] = DIV (1+g) 1 / (1+ re)1
To avoid fraction multiply all by (1+re) (i.e. taking LCM)
P (1+re) – P (1+g) = DIV (1+g)
P + Pre –P – Pg = DIV (1+g)
Cancelling P the expression will be
Pre – Pg = DIV (1+g)
P (re – g) = DIV (1+g)
P = DIV (1+g) / (re – g)
Where DIV (1+g) = DIV1 … So
P = DIV1/ (re – g)
 EQUITY VALUATION (BASIC PRACTICE)
Stock A is expected to pay dividend of $0.5 for the next three years per annum. The required return on similar
equities is 10%.

YEARS CALCULATION ($) PV

1 D1= 0.5

0.5/ (1+0.10)1 0.45

2 D2 = 0.5

0.5/ (1+0.10)2 0.41

3 D3=0.5

0.5/(1+0.10)3 0.38

Total 1.24

Stock B is expected to pay a dividend of £3 for the next two years and then £4 forever. The required return on
similar equities is 7%.

YEARS CALCULATION ($) PV

1 D1= 3

3/ (1+0.07)1 2.80

2 D2 = 3 2.62

3/ (1+0.07)2

Then D3 = $4 FOREVER

USE PERPETUITY WITHOUT GROWTH

49.91
P2 = D3/r = 4/0.07 = 57.14/ (1+0.07)2

TOTAL 55.33

Stock C is expected to pay a dividend £10 next year then £5 forever. The required return on similar equities is 8%.

YEARS CALCULATION ($) PV

1 D1= 10

10/ (1+0.08)1 9.26

2 Then D2 = $5 FORVER

USE PERPETUITY
57.87
P1 = D2/r = 5/0.08 = 62.50/ (1+0.08)1

TOTAL 67.13
Stock D is expected to pay an annual dividend of £5 forever. The required return on similar equities is 9%.

YEARS CALCULATION ($) VALUE

TODAY

1 Dividend = 5 forever

P0= D1 /r = 5/0.09 55.56

TOTAL 55.56

Stock E is expected to pay a dividend of £0.8 next year, followed by £1.20 in year 2 then £1.40 in year 3 with
dividend growth expected to be 3% per annum thereafter. The required return on similar equities is 7%.

YEARS CALCULATION ($) PV

1 D1= 0.8

0.8/ (1+0.07)1 0.75

2 D2 = 1.2

1.2/ (1+0.07)2 1.05

3 D3=1.4

1.4/(1+0.07)3 1.14

D4 = D3 (1+g)

D4 = 1.4 (1.03) = 1.442

USE PERPETUITY WITH GROWTH

P3 = D4/(r – g) = 1.442/(0.07- 0.03)

29.43
=36.05/ (1+0.07)3

Total 32.37

Stock F is expected to pay a dividend of £4 next year, £3 in year 2, with dividend growth expected to be 5% per
annum thereafter. The required return on similar equities is 7%.

YEARS CALCULATION ($) PV

1 D1= 4

4/ (1+0.07)1 3.74

2 D2 = 3

3/ (1+0.07)2 2.62

D3 = D2 (1+g)

D3 = 3 (1.05) = 3.15

USE PERPETUITY WITH GROWTH

P2 = D3/(r – g) = 3.15(/0.07- 0.05)

137.57
=157.5/ (1+0.07)2

Total 143.93
Stock G is expected to pay a dividend of £5 next year with dividend growth expected to be 4% per annum
thereafter. The required return on similar equities is 8%.

YEARS CALCULATION ($) PV

1 D1= 5

5/ (1+0.08)1 4.63

D2 = D1 (1+g)

D2 = 5 (1.04) = 5.2

USE PERPETUITY WITH GROWTH

P1 = D2/(r – g) = 5.2(/0.08- 0.04)

=130/ (1+0.08)1 120.37

Total 125.00

Stock H is expected to pay a dividend of £4 next year with dividend growth expected to be 10% per annum for the
first three years before settling down to 4% a year thereafter. The required return on similar equities is 9%.

YEARS CALCULATION ($) PV

1 D1= 4

4/ (1+0.09)1 3.67

2 D2 = 4 x 1.10 = 4.4

4.4/ (1+0.09)2 3.7

3 D3= 4.4 x 1.10=4.84

4.84/(1+0.09)3 3.74

D4 = 4.84 x 1.04 = 5.0336

USE PERPETUITY WITH GROWTH

P3 = D4/(r – g) = 5.0336(/0.09- 0.04) =

100.672/ (1+0.09)3 77.74

Total 81.48
Stock I is expected to pay a dividend of £4 next year (t=1) with dividend growth expected to be 10% per annum
for the next first three years ( t= 2,3,4) before settling down to 4% a year thereafter (t=5 …). The required return
on similar equities is 8%

YEARS CALCULATION ($) PV

1 D1= 4 3.70

4/ (1+0.08)1

2 D2 = 4 x 1.10 = 4.4 3.77

4.4/ (1+0.08)2

3 D3= 4.4 x 1.10=4.84

4.84/(1+0.08)3 3.84

4 D4 = 4.84 x 1.10 = 5.324 3.91

5.324/(1+0.08)4

D5 = 5.324 x 1.04 = 5.53696

USE PERPETUITY WITH GROWTH

P4 = D5/(r – g) = 5.53696(/0.08- 0.04) =

138.424/ (1+0.08)4 101.75

Total 116.97

Basic phenomenon
P0 = DIV1/(r -g)
P1 = DIV2/(r -g)
P2 = DIV3/(r -g)
EXAM TYPE QUESTIONS

QUESTION 1

Assume that Lyra plc’s free cash-flows grow at 5% per year forever. This growth is not affected by the firm’s pay
out policy. The first free cash flow per share in the next year (year 1) will be $3. The discount rate is 15%. Lyra plc
is considering two
potential pay out policies:

Policy A:
Pay out all free cash flows as dividends. The first dividend will be paid in year 1.
a) What is the share price today? (6 marks)
b) What will be the cum-dividend and ex-dividend prices in year 1 and year 2? (5 marks)

Policy B:
Lyra plc uses year 1’s free cash flow to repurchase shares. After the repurchase, the firm will pay out all future
free cash flows as dividends starting from year 2.
a) What fraction of total shares can be repurchased in year 1? What is the dividend per share in year 2 and year
3? (6 marks)
b) What is the ex-dividend price and cum-dividend price in year 2? (3 marks)

Answer

Policy A (All cash flows paid as dividends)

a)
P0 = D1/(r – g) = 3/ (0.15-0.05) = $30
b)
Cum-div price
P1 = D2/(r – g) = (3 x 1.05) = 3.15/ (0.15-0.05) = $31.5
Ex- div price = 31.5 – 3 = $28.5

Policy B (Company used cash flows of year 1 to repurchase shares and will pay dividends from year 2)
a)
Fraction of shares repurchased = $3/31.5 = 0.0952 = 9.52%
So now D2 = 3.15/ (1 - 0.0952) = $3.48
D3 = 3.48 x 1.05 = $3.654
b)
Cum-div price
P2 = D3/(r – g) = 3.654/ (0.15-0.05) = $36.54
Ex- div price = 36.54 – 3.48 = $33.06

QUESTION 2
a) The stock of DRAM PLC is currently selling for £20 per share. Earnings per share in the coming year are
expected to be £3.50. The company, whose capital structure consists solely of equity, has a policy of paying out
25% of its earnings each year in dividends. The remaining part is retained and invested in projects that earn a 5%
internal rate of return per year. This situation is expected to continue indefinitely.

i) Show that the growth rate g in earnings that is consistent with a pay-out ratio PYT and return on equity ROE is g
= (1 – PYT)*ROE. [5 marks]

ii) Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-
growth Dividend Discount Model, what rate of return do DRAM’s investors require? [5 marks]

iii) By how much would DRAM’s stock price change if all its earnings were paid as dividends and nothing was
reinvested? [5 marks]

b) Clear stream has made the decision to invest in a new project with a high positive NPV. Before the investment
decision has been announced to the public, a director of Clear stream however buys shares under an assumed
name and makes an enormous profit by selling them just after the new investment is eventually disclosed to the
world but before the project generates any cash flow. What do these facts tell us about the efficiency of this stock
market? [5 marks]
ANSWER
a (i)
g= [NI (t1) – NI (t0)]/ NI (t0)………. (i)
WHERE NI (t1) = NI (t0) + [ NI (t0) (1 – PYT)*ROE)]
Retentions from last yr income portion invested at a particular rate
Putting the value of NI (t1) in equ (i)
g = NI (t0) + [NI (t0) (1 – PYT)*ROE] - NI (t0)/ NI (t0)
As NI (t0) cancels out. So
g = (1 – PYT)*ROE
note ‘g’ assumes that all retentions are invested

a(ii)
P0= D1 /(r-g)
So r= (D1 /P0) + g= 3.5 x 25% = (0.875/20) + 0.0375=0.08125=8.125%
g = br = 0.75x 0.05 = 0.0375

a (iii)
P0= D1 /r = 3.5 x100 % = 3.5/0.08125= $43.07
Change in price = 43.07- 20 = $23.07

b)
Weak form = only reflects past prices information
Semi strong form = reflects past prices + publicly available information
Strong form = reflects past prices + publicly available information + insider information
The fact that a director of Clear stream buys shares under an assumed name and makes an enormous profit by
selling them just after the new investment is eventually disclosed is consistent with capital markets being
inefficient in the strong form and efficient in the semi-strong form.